Foreign Direct Investment, Trade & Geography
Summary
Chapter 15-21, 25 (page 635 – end)
Chapter 15
Foreign direct investment
- Foreign direct investment (FDI): the flow of funding provided by an investor or a
lender (usually a firm) to establish or acquire a foreign company or to expand or
finance an existing foreign company that the investor owns and controls.
- International portfolio investment: foreign securities investments that do not
involve management control.
- Foreign direct investment is any flow of lending to, or purchases of ownership in, a
foreign firm in which the investor (usually a firm) has (o gains) ownership of 10
percent or more of the foreign firm.
Multinational enterprises
- Multinational enterprise (MNE): a firm that owns and controls operations in more
than one country.
- Parent firm: headquarters or base firm, located in home country.
- Foreign affiliates: owned by parent firm, located in host country.
- A multinational firm is more than just the flow of FDI:
o Foreign affiliates usually receive only part of total financing from FDI flows.
o Multinational enterprise transfers many other things to its foreign affiliates in
addition to the FDI.
- Parent firm wants to reduce risks to which its foreign activities are exposed, so FDI
provides little of the affiliates’ total funding:
o Unexpected changes in exchange rates.
o Political risk: government of a host country can alter its policies in a way that
harms the multinational enterprise.
FDI: history and current patterns
- Flows of FDI: measure new equity investments and loans within MNEs during a
period of time.
- Stocks of FDI: measure the total amount of direct investments that exist at a point in
time.
Why do multinational enterprises exist?
- Multinationals are not simply a way of shifting financial capital between countries
based on national differences in returns and risks.
- Five arguments provide a good explanation of why MNEs exist:
1. Inherent disadvantages of being foreign
o MNE does not have the native understanding of local laws, customs,
procedures, practices and relationships.
o Extra costs of maintaining management control.
o Lack useful connections with political leaders, hostility from government.
2. Firm-specific advantages (to overcome inherent disadvantages)
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, o Firm-specific advantages: one or more assets of the MNE that are not assets
held by its local competitors in the host country.
o It must be profitable for a MNE to own and manage a foreign operation,
rather than adopting some other way of earning profits.
o Two questions when a firm wants to earn profits by selling to local buyers in
the foreign country:
Should the firm sell to foreign buyers by exporting from its home
country, or should the firm set up local production in the foreign
country to produce the products that are sold to the foreign buyers?
Should the firm license local firms in the foreign country to use its
advantages in their own operations that serve the foreign buyers, or
should the firm set up foreign operations that it owns and controls?
3. Location factors (that favor foreign production over exporting)
o Location factors: all of the advantages and disadvantages of producing in one
country or in another country.
o Four key location factors:
Comparative advantage: effects of resource availability on costs.
Scale economies.
Governmental barriers to importing into the foreign country.
Trade bloc.
4. Internalization advantages (that favor direct investment over contracting with
independent firms)
o License: agreement for one firm to use another firm’s asset, with restrictions
on how the asset can be used and with payments for the right to use the
asset.
Advantage: firm avoids inherent disadvantages of establishing and
managing own foreign operations.
o Internalization advantages: advantages of using an asset within the firm
rather than finding other firms that will buy, rent or license the asset.
Avoiding transaction costs and risks of licensing an independent firm.
o The importance of internalized use of firm-specific intangible assets explains
why FDI occurs to a greater extent in high-technology industries and
marketing-intensive industries than it does in standard-technology industries
or less-marketing-intensive industries.
5. Oligopolistic rivalry (among MNEs)
o MNEs can use their decisions about FDI as part of their competing strategies.
o MNEs can use FDI to try to mute competition and enhance their market
power.
MNE may acquire foreign firms that are beginning to challenge their
international market position.
MNE may set up an affiliate in the home country of one of its rivals, to
establish a competitive threat to this rival.
Taxation of multinational enterprises’ profits
- The host-country governments tax the profits of the local affiliates of the
multinational, and the home-country government taxes the parent company’s local
profits earned on its own activities.
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, - Key question is whether the home-country government also imposes any taxes on
the profits earned by the foreign affiliates of the parent company.
- Two important issues:
o MNE can shop around among countries and locate its affiliates in the
jurisdictions of governments offering low tax rates.
o MNE can use transfer pricing and other devices to report more of their profits
in low-tax countries, even though they were earned in high-tax countries.
Transfer pricing: setting of prices for things that move between units
of the company.
MNEs and international trade
- 1/3 of the world’s international trade in goods occurs as intrafirm trade between
units of the MNEs located in different countries.
- 1/3 of the world’s international trade involves a MNE as the seller (exporter) or
buyer (importer).
- When transport costs and trade barriers are low enough, FDI can be used to reduce
total costs by locating different stages of overall production in different countries.
- Trade among parents and affiliates engaged in different stages of production shows
that FDI and trade can sometimes be complements.
- When foreign affiliates undertake the same kind of production as that of the parent
firm or other affiliates, FDI and trade can be substitutes. Trade-off between:
o Centralizing production in one or a few locations and exporting to many other
countries, to achieve scale economies.
o Spreading production to many host countries where the buyers are, to
reduce transport costs, to avoid actual or threatened barriers to importing
into these countries, or to gain local marketing advantages.
- FDI is likely to promote or complement trade:
o Affiliates’ production of the final product requires components and materials
as inputs into production, which can be acquired from the parent firm,
affiliates in other countries or independent suppliers in other countries.
o FDI can increase trade in final products because the affiliate improves the
marketing of all of the firm’s products in the host country. Affiliate displaces
some trade for the specific products that it produces, but it expands trade
through better local marketing of other products produced by the MNE in
other countries.
- FDI is somewhat complementary to international trade.
- FDI is associated with higher home exports of products in same broad industry.
Should the home country restrict FDI outflows?
- Several key effects can be identified:
o Effect on workers and others who provide inputs into production in home
country.
o Effect on owners of MNEs based in home country.
o Effect on government budget, especially the effects on government tax
revenues.
o Any external benefits or costs associated with direct investments out of the
country.
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, - Producer side of market can be divided into:
o Workers and other providers of inputs.
o Owners of MNEs.
- Workers and home-country government lose from FDI.
- Owners of MNEs gain from FDI.
- FDI may carry external technological benefits out with it.
- Key reason for the neutral-to-supportive home policies is that the MNEs have used
their resources and common interests to enhance political influence through
lobbying.
Should the host country restrict FDI inflows?
- Standard static analysis of FDI finds that workers in the host country gain from
increased demand for their services, as do other suppliers of inputs to the affiliates
of foreign MNEs.
- Host country government gains from taxes collected on affiliate profits, as long as
these exceed the extra costs of any additional government services provided to the
affiliates.
- Domestic firms that must compete with the affiliates lose.
- Concern that foreign MNEs will exercise substantial market power to raise prices
once they have thinned the ranks of local competitors.
- Host country must weigh indirect economic effects when deciding what its policy
toward incoming FDI should be.
- MNEs used to be seen as a threat:
o Economic gains were tilted toward MNEs because of their economic size and
monopolistic power, leaving little for the host counties.
o MNEs used capital-intensive production methods that were not suitable to
developing countries.
o Denationalization of host country’s industries by displacing local firms.
o MNEs acted as an extension of the power of their home-country
governments, and they enlisted the support of home-country governments
to pressure host country in a confrontation.
- Countries that began to grow fastest were those that adopted outward-oriented
policies.
- MNEs were viewed more favorably as a source of inflows of foreign capital and as a
set of investors that did not rush to the exits at the firs whiff of trouble.
Migration
- International migration: the movement of people from one country (sending
country) to another country (receiving country).
How migration affects labor markets
- Moving also brings costs to the migrants.
- Freer migration makes wage rates in the migrant-related occupations more equal
between countries.
- Directly competing workers in the receiving countries have their pay lowered,
relative to less immigrant-threatened occupations and relative to such non-labor
incomes as land rents.
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